Capital losses can offset capital gains. In layman’s terms, if you’re winning in a particular stock then you can offset that (not pay capital gains taxes on it) by selling that stock and some other stock in which you’re losing money. If let’s say you’ve had zero gains and a bunch of losers, the IRS lets you take up to $3,000 of those losses and offset some other type of income (your job). All this predicated on the fact that you sell the stock before this Friday, Dec. 31st. This is the reason why you’ll start hearing market professionals talk about selling your losers to offset the winners.

You have two types of winners but only one type of loser.

All Losers Are The Same:

Example: You bought 100 shares of XYZ Holdings at $100 a share and it went down the tubes and is trading at $20 a share now. When you sell it (and only after you sell it, because then it’s a realized loss), you’ve incurred a loss of $8,000. It doesn’t matter how long you’ve had this dog because Uncle Sam doesn’t want any of your money so he doesn’t care.

Short Term Winner:

If you’ve held a stock for less than a year (so you bought it sometime in 2005), then it’s subject to short term capital gains which is your marginal tax rate. It means what you’ve earned in the stock is treated as ordinary income, as if you’ve taken a second job. If you wanted to offset a loser, this is the winner you want to sell because it’s being taxed the most. Example: Let’s say that you’re in the 25% marginal tax bracket and you have watched your 100 shares of ABC Construction Corp soar from your purchase price of $5 to $100, or an unrealized gain of $9,500. If you didn’t have a loss to offset it, you’d pay 25% tax on $9,500 – $2,375 in taxes. You decide that you want to sell XYZ and incur the realized loss of $8,000 so your net is now a mere $1,950. Your tax bill drops from $2,375 to $487.50. But, you don’t need to sell your entire stake in your winner, ABC, you can just sell enough to cover the loss if you still believe ABC has legs.

Long Term Winner:

If you’ve held a stock for more than a year (so you bought it in 2004), then it’s subject to long term capital gains which is only 15%. This means your tax savings are less but the same example from above works.

Wash Rule:

To prevent someone from selling and then immediately buying back their winners, you can’t offset if you re-enter a stock within 30 days. On the 31st day after you sell the stock, you can buy back in. Nothing prevents you from buying back in within 30 days, but you lose the privilege of offsetting your losses.

The thirty-day rule also applies to buying into your position before you sell out at a loss. For example, if you buy into a stock, you have to wait thirty days before selling your existing losing position if you want to write off the loss.

Clock’s ticking… only four more trading days in the year (market’s closed tomorrow in observation of Christmas Day)!